Inside The Buy-side® 3Q14 by Corbin Advisors

INSIDE THE BUY-SIDE®

THIRD QUARTER | ISSUE DATE: JULY 9, 2014

Following

a cool start to the year in the first quarter of 2014, equity markets returned to form in the second with the Dow and S&P 500 touching all-time highs. Indeed, the S&P reached closing highs more than a dozen times in the quarter. At the closing bell on June 30, the Dow gained 2.2% in the quarter, the S&P 500 added 4.7%, its sixth consecutive quarterly advance, and the NASDAQ finished 5.0% higher. In our ongoing effort to track investor sentiment and expectations, we surveyed 50 financial professionals globally and across multiple industry segments and investment styles.1 In total, participating institutions manage upwards of $591 billion in equity assets. Equity investors seemingly shrugged off geopolitical crises in the Ukraine and Iraq as well as further downward revisions to first quarter U.S. GDP, which is now seen as having contracted at a 2.9% annual rate. Rather, they seemed to embrace continued, modestly improving data on jobs, housing and manufacturing in the U.S. and appear hopeful that corporations can grow into their current valuations with only limited help from the economy. Looking overseas, the ECB joined Japan in taking bold monetary actions in an attempt to avoid deflation, as the central bank lowered its benchmark interest rate by 10 bps to 0.15%, while also cutting its deposit rate into negative territory, substantially easing financial conditions. Additionally, the World Bank continued to lower its forecasts for developing countries, now estimating growth of 4.8% for the year, down from its January estimate of 5.3%.

Investment Style

Geography

North America | 50% Europe | 50%

Sector

Timeframe: June 13 – 25, 2014

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Key Trends 

Investor sentiment is more positive, as 69% of contributors say they are cautiously optimistic to bullish, up from 49% last quarter



As the second quarter earnings season gets underway, 80% of surveyed investors expect results to be in line with or better than consensus expectations



Perceived executive management tone is also trending more positive; 32% note conversations are more upbeat, up from just 17% last quarter



Participants report that consistent cash flow, balance sheet flexibility and operating margins are the most important financial characteristics in the current environment



47% state that market valuations are sustainable, up from 18% in the previous quarter



Investment professionals report favoring the IT, healthcare and industrial sectors and express bearish sentiment toward telecom, utilities and consumer staples



More than half see organic and EPS growth improving, a reversal from last quarter’s forecast of declines



Dividends continue to be seen as the best use of excess free cash



Macro indicators most widely followed by the survey group include employment data, PMI and GDP



Regarding the global macro outlook, geopolitical unrest tops investor concerns, followed by a slowdown in China, Fed uncertainty and EU stagnation



76% believe the Fed will raise interest rates next year with 40% maintaining a hike will likely occur in the back half of 2015



IR Best Practice: Leverage the sell side as ongoing research confirms that analysts remain an important conduit to the buy side ‒

90% report utilizing or referencing sell side research and models to varying degrees

Equity Markets Resume Their Uptrend after Early Caution Following an April dip that seemed to promise more of the first quarter’s sluggishness, U.S. stocks more than offset the early losses to post solid gains for 2Q14. Indeed, even small-cap investors joined the parade, as the Russell 2000 index gained 5.2% in June, its best monthly advance since last September.

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Energy emerged as the top performing S&P 500 sector during the quarter, up 17%, buoyed in part by a sharp rise in crude prices due to escalating tensions in the Middle East. As well, utilities continued strong, finishing higher by 12% after gaining 9% in 1Q14, while consumer cyclical stocks underperformed, gaining just 3% for the quarter. 2Q14 Market Performance 105 100 95 90 6/30/14

6/23/14

6/16/14

6/9/14

6/2/14

NASDAQ +5.0%

5/26/14

5/19/14

5/12/14

5/5/14

4/28/14

4/21/14

4/14/14

4/7/14

3/31/14

DJIA +2.2%

S&P 500 +4.7%

Earnings Expectations Levitate After Falling Sharply in 1Q14 Expectations for 2Q14 results are substantially more positive than they were in the previous quarter. Whereas 77% expected 1Q14 results to be in line with or worse than consensus estimates, currently 80% of respondents anticipate earnings to be in line with or better than consensus. Besides the expectation of a recovery from the weather-related drag seen in the first quarter, participants also note increasingly positive commentary from company executives and assert that “liquidity driven markets” and continued cost cutting will support bottom- line results. Those that expect 2Q14 results to be worse than consensus attribute their skepticism to “further revenue headwinds” and overly optimistic estimates from the sell side. What Was Your Opinion of 1Q14 Earnings Results?

What Are Your Expectations for 2Q14 Earnings Results Relative to Consensus?

Better Than | 28%

Better Than | 39%

In Line | 54%

In Line | 41%

Worse Than | 18%

Worse Than | 20%

Looking back at results for 1Q14, the majority of participants, or 54%, indicates results were in line with expectations, attributing their sentiment to the impact of the severe winter as well as companies’ ability to deliver results through “cost-driven earnings.” www.corbinperception.com

Further, 28% of investors consider 1Q14 results better than expected, citing low volatility, resilience in the U.S. bond market and the fact that there is “not much of an alternative” to equities. Finally, 18% assert they were disappointed by 1Q14 results given weaker-thanexpected top-line growth and forward-looking guidance. “Many of the companies which I follow had weather-related issues which led to below expectations for most but my belief is that most investors had already factored this into the equation. It turned out to be mostly right.” Growth, Generalist “Commentary coming out of 1Q14 was much better than the market expected and revisions have started moving higher.” GARP, Multi “After the strong market performance in 1Q14, I expected a slowdown in the market advance. This is what has happened in 7 out of the past 10 instances when the market indexes advanced 20% or more in a prior year.” Core Growth, Generalist “While analysts had written down their earnings estimates throughout most of the quarter, actual revenue reported versus estimated was weaker than expected. Forward guidance by corporations was also somewhat disconcerting.” Core Value, Generalist

In the current environment, surveyed investors confirm that the most important financial characteristics considered are: 

65% | Consistent cash flow



47% | Balance sheet flexibility



47% | Operating margins



41% | Earnings growth potential



39% | Top-line growth



35% | Organic growth “Having debt these days at lower rates appears to be a prudent measure, especially if used to fuel growth.” Growth, Generalist “Balance sheet strength implies the ability for a firm to actively pursue growth, either organically or through acquisition/competitor termination. Consistent cash flow is important, primarily from operating and investing activities.” Core Value, Generalist

“I want to see increasing revenues through either expanding market share or increasing pricing power or both.” Core Value, Generalist

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Market Sentiment Rises As equity markets regained steam in 2Q14 after a flat commencement to the year, investor sentiment turns higher, with 51% of surveyed respondents describing themselves as cautiously optimistic compared to 39% last quarter. Further, those reporting their outlook is bullish increased to 18% from 10% quarter-over-quarter amid optimism about acceleration in economic activity, a more positive management tone, a pickup in M&A, strengthening corporate balance sheets and continued accommodative monetary policy. Finally, the percentage of investors who describe themselves as neutral, neutral to bearish or bearish all eased from the previous quarter. Investor Sentiment -- Prior Quarter

Investor Sentiment -- Current Quarter

Bullish | 10%

Bullish | 18%

Cautiously Optimistic | 39%

Cautiously Optimistic | 51%

Neutral | 25%

Neutral | 14%

Neutral to Bearish | 20%

Neutral to Bearish | 13%

Bearish| 6%

Bearish| 4%

In yet another measure highlighting optimism, our quarterly channel check on performance metrics reveals contributors are more confident in companies’ ability to deliver continued upside in organic growth, EPS and FCF than they were last quarter. Organic Growth

EPS Growth

FCF Growth

70%

60%

50%

40%

30%

20%

10%

0% 4Q13

1Q14

2Q14

Improving

0% 4Q13

1Q14

Staying the Same

2Q14

4Q13

1Q14

2Q14

Worsening

“The economy is improving, companies are generally generating cash but valuations are above average so good values are difficult to find.” GARP, Generalist

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“Large-cap indices are at record highs in the U.S. and surprisingly strong in Canada due to a resurgence, to some degree, in resources.” Growth, Generalist “Given forward guidance and also certain macroeconomic/political indicators, the environment appears to be one of ‘don’t confuse me with the facts,’ as markets continue be bid up, volumes appear to be stagnating and equities appear fully valued, if not modestly stretched.” Core Value, Generalist “Stocks are fully priced and probably overpriced but there is no alternative.” Core Growth, Multi

Management Tone Turns Slightly More Positive Surveyed investors report that executives with whom they interact have turned somewhat more optimistic than in the previous quarter. Notably, respondents reporting an unchanged but “bullish” stance rose to 32% from 17% last quarter while the number of respondents hearing an unchanged but “cautious” tone from management fell to 50% from 60%. Those who report a “less negative” tone remain virtually unchanged. Investors attribute the slight increase in optimism to potential upside surprises after a weak first quarter, also noting that, “liquidity will be with us for a long time.” Concerns still center on an uncertain domestic political climate, geopolitical tensions, emerging market weakness and stretched valuations. Management Tone -- Prior Quarter

Management Tone -- Current Quarter

Unchanged (Bullish) | 17%

Unchanged (Bullish) | 32%

Unchanged (Cautious) | 60%

Unchanged (Cautious) | 50%

Less Negative | 13%

Less Negative | 12%

More Negative | 10%

More Negative | 6%

“Most companies have been cautious in their stance because of weaker first quarter numbers and a challenging start to the second quarter but that might just be for the companies we follow.” Growth, Generalist “Management teams have largely been talking up April and May activity off of a tough first quarter operating environment.” GARP, Multi “The first quarter was bad but we are seeing improvements in April and May. I am more bullish on the second quarter.” GARP, Generalist

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Valuations Seen as Fair Concerning the sustainability of current market valuations, investor views are more constructive than they were last quarter. Previous Quarter Are Markets Sustainable at Current Levels?

Current Quarter Are Markets Sustainable at Current Levels?

No | 35%

No | 31%

Yes | 18%

Yes | 47%

Yes with Caveats | 35%

Yes with Caveats | 22%

Depends | 12%

Just less than half, or 47%, state unequivocally that market valuations are sustainable, up from 18% in the previous quarter. Participants primarily attribute their views to growth in earnings, proclaiming “EPS will grow to justify” valuations. Additionally, investors assert there is “no recession on the horizon yet” and note that inflation is under control while the U.S. and EU economies continue to show gradual improvement. Moreover, 22% assert that current valuations are only sustainable should interest rates remain low and if the “unbelievable liquidity” persists. Furthermore, respondents note that valuations can hold up “in the short run” and “if top-line growth picks up” but remain concerned should the Fed employ a more hawkish stance. Finally, 31% contend that current market valuations are not sustainable, noting that stocks are “too expensive relative to growth” and that “growth assumptions are too high” while “easy money has propped up valuation in almost all equities.” “We are near median valuations and I believe growth will accelerate and margins are sustainable.” GARP, Multi “Valuations are above average but reasonable. Low rates should mean higher valuations so we could be sustained at this level.” GARP, Generalist “For many stocks the growth assumptions are too high to support current valuations.” Core Value, Generalist

Investment Themes and Sector Trends Surveyed investment professionals indicate that dividend, out-of-favor and high quality/low beta stocks are the most attractive investment themes while IT, healthcare, industrials and energy are

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the sectors earning the most bullish sentiment given their position in the cycle, growth potential, strong fundamentals and favorable valuations. Of note, while IT remains a relative favorite among those surveyed, bullish sentiment declined from last quarter while bearish sentiment more than doubled. Meanwhile energy, one of the more bearish sectors cited last quarter, is seen as a prime beneficiary to rising inflation and “ongoing geopolitical tensions”. Most Attractive

Least Attractive 55%

53% 41%

39%

32% 17%

Dividend Yield

Out-of-Favor Stocks

High Quality/ Low Beta

Low Quality/ High Beta

Defensive

Early Cycle

Similar to last quarter, participants maintain they are avoiding low quality/high beta, defensive and early cycle themes. Additionally, investors are bearish on telecom, utilities and consumer staples, as these typically high-yielding sectors are viewed as “disadvantaged in an interest rate normalization period,” as “PEG ratios are too high” and are seen underperforming given the cyclical nature of the recovery. “Out-of-favor stocks are where we are currently seeing the most value.” Growth, Generalist

“I favor high quality/low beta stocks with solid balance sheets and stable to growing revenues and earnings. I would put large-caps and multinationals in the same bucket as their revenues are diversified outside the U.S.” Core Value, Generalist “Dividend yield implies that the business model is either a quasi-GSE or regulated monopoly (utilities) with limited organic growth at the whim of its benefactors. Low quality/high beta has had its run.” Core Value, Generalist Sector Snapshot

13%

15%

30% 17%

49%

47%

Healthcare Industrials

45%

Energy

39%

24%

32% 18%

40%

12%

Financials Consumer Materials Consumer Telecom Discretionary Staples Bullish

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31%

19%

38% 6% Utilities

0% 2% Metals & Mining

Bearish

“I like cyclical sectors because valuations are cheaper than stable sectors and I believe economic conditions are improving.” GARP, Generalist “Energy and technology are later-cycle sectors and valuations are supportive as well as in financials, which should benefit as rates rise.” GARP, Multi “Consumer discretionary may struggle because household income is not growing.” Core Growth, Multi

“I am bearish on telecom due to cannibalistic pricing power in addition to low barriers for other non-traditional telecom companies gaining entry to this sector, Comcast for example.” Core Value, Generalist

Optimism Abounds Despite Plethora of Concerns Global and geopolitical tensions remain top concerns to investors regarding the sustainability of the equity market rally. The Iraq conflict, combined with ongoing tensions surrounding Russia and the Ukraine, have given investors much to mull over regarding potential market implications of further geopolitical pressure. Top Concerns Prior Quarter

Current Quarter

China Slowdown, Credit Crunch Status of U.S. Recovery Geopolitical Risk Fed Uncertainty (e.g., QE, rising rates, inflation) EU Growth, Fiscal Concerns

Geopolitical Risk China Slowdown, Property Market Fed Policy (e.g., QE, rising rates, inflation) EU Deflation/Stagnation U.S. Employment Market, Policy Concerns

When Will the Fed Raise Rates?

A deceleration in China’s economy continues to weigh on the minds of investors as the status of the world’s soon-to-be largest economy continued to slow. During the second quarter, China’s economy grew only 7.4% year-over-year, down from last quarter’s 7.8% growth. Despite stabilization efforts, it is expected to slow further. The Yuan also declined considerably during the quarter against the U.S. dollar, as would be expected with the weakening economic backdrop. Continuing, investors remain moderately concerned yet hopeful about the rate of economic growth in Europe. Much to the satisfaction of the global markets, ECB head Mario Draghi announced a 10 bps cut to the ECB’s main refinancing rate to 0.15% from 0.25%. Domestically, while the Fed has been successful in reducing its bond buying program, the sharp contraction in first quarter U.S. GDP showed that bumps in the road could still arise and put a crimp in economic growth.

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Additionally, what can be referred to as the equivalent of a political stalemate in Washington, U.S. politics and the potential for misguided, unfriendly tax and regulatory policies remain a nagging concern. “The political climate, a European slowdown, dollar disdain and Mid East turmoil are all of sufficient concern to warrant a cautious approach to the business decision process.” Core Value, Generalist “My concerns relate to inflation, geopolitical events and anemic job growth which have the potential to negatively impact housing demand.” Core Value, Multi “GDP growth and inflation are areas of concern.” Core Growth, Generalist

Economic Indicators Front and Center When we first started tracking buy side sentiment (2006), it was a rare occurrence to find investors tracking economic data. Fast forward to the post-great recession era, and the financial community is very much tuned into the economy. When asked which macroeconomic indicators they are monitoring most closely, participants predominantly cite U.S. jobs data, PMI (purchasing managers index) and GDP growth as top gauges to the health of the global economy. April

May

June

July Est.

304,000

224,000

288,000

+64,000

221,000

Avg. Hourly Earnings Growth

0.00%

0.21%

0.25%

+0.04%

0.22%

U.S. Personal Income Growth

0.54%

0.30%

0.40%

+0.10

0.27%

54.9

55.4

55.3

-0.10

55.4

4Q13

1Q14

2Q14 Est.

2.6%

-2.9%

-5.5%

3.6%

U.S. Nonfarm Payrolls

U.S. Manufacturing PMI U.S. GDP Growth Rate

Investors assert that a falling unemployment rate does not necessarily equate to healthy job gains, as wage growth, average hourly earnings and personal income continue to languish. Additionally, participants consider government debt levels, actions of central banks along with interest and inflation rates as key macro indicators. “Inflation and employment statistics are key indicators. I think the next bear market could be brought on by higher rates and I think the Fed looks at those two things as drivers of policy.” GARP, Generalist “Indicators of importance include the unemployment rate, hours worked and the average hourly wage rate.” Core Growth, Generalist “I watch GDP, PMI, personal income growth and labor market data.” Core Value, Generalist

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Predictions for a Rising Rate Environment While the Fed looks to conclude its bond buying program by year end, 36% of respondents believe the central bank will hike its benchmark interest rate in the first half of 2015, attributing their views to a pick-up in the domestic economy, the need to control irrational exuberance, and the belief that the Fed will successfully reach its 2% inflation target.

When Will the Fed Raise Rates? 36% 24% 16%

18%

6% Late 2014

1H15

3Q15

4Q15

2016

Continuing, 40% of investors believe the Fed will raise rates in the second half of 2015, noting recent dovish commentary from Chairman Yellen suggesting rates will remain low for an extended period. Additionally, participants point to the fact that the Fed has yet to reach its 2% inflation target, further necessitating accommodative monetary policy. Meanwhile, 18% of respondents assert that continued housing market weakness and low inflation will lead the Fed to defer a rate hike until 2016. Finally, a small minority expect a rate hike in late 2014 due to an improving domestic economy and the need for markets to become “conditioned” for tighter monetary policy. “I think economic statistics will begin to improve at a faster rate, necessitating a rate hike within 12 months.” GARP, Generalist “This Fed has given appearances of dovishness and fears market reactions. Politics may push a rate hike out until 2016.” Deep Value, REIT “Wanting to ensure this recovery continues, the Fed has communicated it will keep rates low. Inflation, as measured by the Fed, appears to be within an acceptable measure. It will continue to un-taper; look to inflation as the primary gauge to raise rates.” Core Value, Generalist “It might happen in the first half if the economy gains further strength but low interest rates have become the normal operating environment for some time and rate hikes need to be orderly so as not to create a downturn.” Growth, Generalist

Dividends Continue Their Dominance Desire for dividend growth remains intact as the preferred method for deploying excess free cash to shareholders as valuations continue to make share repurchases an unpopular choice. Reinvestment is also a top preference, up considerably from last quarter and in line with its status in the third and fourth quarters of 2013, when it was also the top choice. Preference for M&A increased slightly from the previous quarter while the percentage of those favoring debt reduction fell to 60% from a high of 71%. www.corbinperception.com

Excess FCF -- Quarterly Trends

83%

95% 81%

66% 71%

91% 76%

89% 87%

83% 81% 66%

65%

72% 71%

69% 68%

60%

44%

42%

3Q13

4Q13 Dividend Growth

1Q14

Reinvestment

M&A

Current

Share Repurchase

Debt Reduction

IR Best Practice: Leverage the Sell Side Research and Models While buy side reliance on sell side research has diminished substantially over the years, our ongoing research indicates the role of the analyst remains intact albeit much altered. Indeed, 42% of surveyed investors acknowledge utilizing sell side research and/or models while 48% conduct their own research but admit to looking at reports. Of note, only 10% of the study group maintains they never referring to sell side material. Corbin Perception delved deeper and asked investors if a sell side analyst’s published research was consistent with what had been communicated to them directly. As such, 55% of respondents indicate that published sell side research at times differed from what had been communicated directly to them but concede that it does not happen often. Participants further note that occasionally analysts sometimes “have a long term view but might have some short term concerns” or they have additional insight on issues that are not published in their reports. Non-deal Roadshows Concerning companies,

meeting participants

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Do You Utilize Sell Side Research?

I Look At It, But Do My Own | 48% I Utilize Their Models & Research | 36% No, Not At All | 10% Yes, I Utilize Their Models | 6%

What is Your Preference For Scheduling Meetings?

No Preference | 51% Prefer Use of Sell Side | 18% Prefer Independent Outreach | 17%

with were

We do not Meet with Companies | 14%

asked if they favor utilizing the sell side to arrange meetings or if they prefer the company reach out independently. Just over half of respondents, or 51%, state that they have no preference while 18%, comprising mostly European investors, prefer the sell side to arrange meetings for them. Of note, 17% of the study group, mainly U.S.-based investors, prefers the company reach out to them directly because it “gives me the most freedom to remain independent”. In closing, we recommend companies continue to develop and foster relationships with the sell side as they can serve as influential conduits of your story but also encourage companies to market independently given that many qualified investors do not always maintain relationships with analysts. Selected recommendations include: 

Consider traveling with a bearish analyst, which provides management the opportunity to positively influence and potentially alter their opinion on the stock



If you have too many analysts, employ a tier system (e.g., quality of research, meetings, industry contacts) and then prioritize management time with top performers



If you have too few analysts, recognize time and investor demand are important factors to launch coverage; selected recommendations include: ‒

Utilize targeting software/third-party firm to assist with marketing efforts; leverage meetings to increase buy side demand that in turn can lead to increased outreach to sell side on the name

‒

Proactively set up onsite meetings and offer the opportunity to meet senior management and/or tour company facilities

‒

Become acquainted with junior analysts and inform them of the investment story

‒

Try to secure inclusion as a presenting company at sell side conferences even if not actively covered by the firm

‒

Arrange a meeting with senior management for an investor that they normally would not meet with as a favor to an analyst



If new to a company, provide your shareholder base and targets to covering analysts and have them identify with whom they have relationships



Recognize that corporate access is part of the sell side’s compensation package; attendance at their sponsored conference may mean more to them than a non-deal roadshow in a select city or vice versa (should be a consideration not a determining factor)



When marketing with the sell side, always request the meeting schedule ahead of time ‒

Suggest additional investors with whom you are interested in meeting

‒

Do not be afraid to push back if schedule is filled with firms that are not ideal targets

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PROVEN METHODOLOGY, PROVEN RESULTS Corbin Perception is a leading investor research and IR advisory firm assisting public companies with driving long-term shareholder value. Our strategic advisory services include: 

Perception Studies



Investor Targeting



Investor Days



Investor Presentations



Investor Communication, Messaging



Strategy Development, Positioning



Retainer Consulting

We leverage our broad company and industry experience, ongoing research on the buy side and knowledge of investor engagement best practices to achieve results. We are passionate about our work and develop relationships that are collaborative and long lasting. Our client value proposition is based on: 1) in-depth understanding of the buy side and investor relations best practices; 2) proven methodology yielding valuable insights and actionable recommendations; 3) strong track record of applying our knowledge to create value; 4) talented team with extensive C-suite and BoD advisory experience; and 5) a commitment to quality, service and client satisfaction. Visit our website or contact us to learn more: www.corbinperception.com info@corbinperception.com (860) 321-7309